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BlackRock, the world's largest asset manager, is advising clients to change old ideas about portfolio management by blending volatility strategies into investment portfolios.

Volatility is an asset class that can be harnessed to increase returns and reduce risk, according to the firm. BlackRock favors selling volatility via futures on the CBOE Volatility Index (VIX), puts on the Standard & Poor's 500 index and other securities, and variance swaps. These short volatility strategies are integrated into the equity allocations of investment portfolios.

The message, delivered in meetings with customers, and articulated in a recent edition of its Investment Insights journal for institutional investors, is timely. The global financial crisis challenged long-held assumptions about how to manage money. Portfolio managers traditionally buy stocks and bonds and other assets based on historical pricing patterns animated by assumptions that the future is much like the past.

Volatility, which is the critical component of options-pricing models, has rarely been a significant portfolio concern for pension and mutual-fund managers and other institutional investors. But the financial crisis has prompted many to consider augmenting Modern Portfolio Theory, a guiding principle in many investment portfolios that advocates diversification as a means of limiting risk.

"Most institutional investors set a static, strategic asset allocation grounded on fixed assumptions about volatility. They do not account for the risk that risk will change," Fred Dopfel and Sunder Ramkumar, two BlackRock strategists, wrote in an essay, "Managed Volatility Strategies: Applications to Investment Policy," published in BlackRock's Investment Insights.

The Crash of 1929 notwithstanding, financial-market crises usually are quickly resolved, so discounting volatility was easier because standard portfolio diversification tended to tamp down portfolio risk. Bonds reduced stock risks, and various types of stocks and bonds further lowered risk. But the global credit crisis showed that correlation—the tendency of assets to behave like one another regardless of their relative merits—can oppress even the most diversified portfolio. When the world trades in unison—usually lower—volatility spikes and share prices sink, creating opportunities to use volatility to minimize damage and lift returns.

Thomas McFarren, part of BlackRock's Global Market Strategies Group, advised in another Investment Insights essay that selling volatility as an equity substitute would have improved portfolio performance, even during the financial crisis.

"Selling volatility on a broad equity index has a positive expected return premium over time, as the seller effectively provides insurance to the buyer of volatility," he wrote in "VIX Your Portfolio: Selling Volatility to Improve Performance."

WHILE TRUE, IT'S TRUER STILL THAT selling volatility in a crisis demands an iron constitution because volatility tends to rise much faster than it falls, especially amid financial chaos. That fact overshadows any study showing that selling volatility is a sound long-term strategy that reduces risk and increases returns, provided investors do not panic.

In practice, many investors think of volatility like a rubber band. They sell volatility when the rubber band is stretched and buy when it is relaxed. This pattern of selling volatility high and buying low hedges portfolios and raises returns—but it requires an expertise uncommon in the investment industry.

BlackRock, however, likes selling equity volatility—not buying it—because of the persistent demand among many investors buying derivatives to hedge portfolios.

In any event, BlackRock's embrace of volatility reinforces the view of major investment banks that volatility is an asset class. When a firm that manages about $4 trillion puts its money where its mouth is, people listen, and some will even follow.